1. Stock Valuation Dr. C. Bulent Aybar Professor of International Finance

2. © Dr. C. Bulent Aybar Review of Basic Concepts Key differences between debt and equity Ownership Structure (private, public; closely/broadly owned) Par Value Authorized Shares; Outstanding Shares; Treasury Stock; Issued Shares Preemptive Rights; Dilution Voting rights (non-voting and super-voting shares), Proxy Form of dividends (Cash, stock, merchandise) International Stock Issues, ADRs, GDRs Preferred Stocks (cumulative, non-cumulative, callable, convertible) Venture Capital (early stage, mid stage, late stage) ; Angel Capital IPO, Investment Banks and Underwriting,

3. Cost of Raising Capital

4. Groupon IPO Costs Groupon Inc raised $700 million after increasing the size of its initial public offering, becoming the largest IPO by an Internet company since Google Inc raised $1.7 billion in 2004. The company is now valued at almost $13 billion after saying it increased the offering by 5 million shares to 35 million in total and pricing them at $20 each, above an initial range of $16 to $18. Groupon paid $42m to investment bankers in the process. The gross cost of the issue was $72m.

5. Global Financial Markets

6. Comparative Cost of Raising Equity Capital Gross Spread=Cost/Size of the Issue

7. © Dr. C. Bulent Aybar Valuation Fundamentals The (market) value of any investment asset is simply the present value of expected cash flows. The “rate” that these cash flows are discounted at is called the asset’s required rate of return. The required return is a function of the real interest rate, expected rate of inflation and the perceived risk of the asset. Higher perceived risk results in a higher required return and lower asset value.

8. Stock Valuation: Basic Common Stock Valuation Equation The value of a share of common stock is equal to the present value of its future cash flows (dividends): where P0P0 =value of common stock DtDt =per-share dividend expected at the end of year t rsrs =required return on common stock

9. © Dr. C. Bulent Aybar Zero Growth Model The zero dividend growth model assumes that the stock will pay the same dividend each year going forward. The equation shows that with zero growth, the value of a share of stock would equal the present value of a perpetuity of D 0 dollars discounted at a rate r s.

10. © Dr. C. Bulent Aybar Constant Dividend Growth Model The constant-growth model assumes that dividends will grow at a constant rate, but a rate that is less than the required return (i.e g<r) The Gordon model is a common name for the constant-growth model that is widely cited in dividend valuation. With a simple manipulation we can simplify the model as:

11. © Dr. C. Bulent Aybar Example Lamar Company, a small cosmetics company, paid the following per share dividends:

12. © Dr. C. Bulent Aybar Example Assuming that investors expect 15% return on their investment in Lamar what should be the market price of the share given the dividend expectations as of end of 2012? –Historical annual growth rate of Lamar Company dividends equals: g=(D 2012 /D 2007 ) 1/5 -1= (1.4/1) 1/5 -1=6.96 ~ 7% 7-12

13. © Dr. C. Bulent Aybar Variable Growth and Stock Value We cannot use the constant dividend growth model to value a stock if the growth rate is not constant. –For example, young firms often have very high initial earnings growth rates. During this period of high growth, these firms often retain 100% of their earnings to exploit profitable investment opportunities. As they mature, their growth slows. At some point, their earnings exceed their investment needs and they begin to pay dividends. Although we cannot use the constant dividend growth model directly when growth is not constant, we can use the general form of the model to value a firm by applying the constant growth model to calculate the future share price of the stock once the expected growth rate stabilizes.

14. © Dr. C. Bulent Aybar Changing Growth Rates Dividend-Discount Model with Constant Long-Term Growth Assuming that the growth changes once, we can utilize the same model we can modify the model to account for changing growth rates. Assume that Growth rate changes after N periods.

15. © Dr. C. Bulent Aybar Variable Growth Model Assuming a single shift in the growth rate, dividends grow at a rate of g 1 in the first N years and at a rate of g 2 thereafter. We calculate the PV or perpetually growing dividends at time N, then discount it to time zero. This is added to the PV of the dividend stream during the initial growth phase:

16. © Dr. C. Bulent Aybar Example The most recent annual (2012) dividend payment of Warren Industries, a rapidly growing boat manufacturer, was $1.50 per share. The firm ’ s financial manager expects that these dividends will increase at a 10% annual rate, g 1, over the next three years. At the end of three years (the end of 2015), the firm ’ s mature product line is expected to result in a slowing of the dividend growth rate to 5% per year, g 2, for the foreseeable future. The firm ’ s required return, r s, is 15%.

17. Solution YearDividends 20121.50 20131.65 20141.82 20152.00 20162.10 P 2012 =P HG +P LG =4.12+13.81=17.93

18. © Dr. C. Bulent Aybar Example: Variable Growth HPH just paid $3.40 dividends. Company expects zero growth next year. –In years 2 and 3 5% growth is expected –in year 4 growth is expected to climb up to 15% –In year 5 and thereafter a constant growth of 10% is expected If you expect 14% required return, what should be maximum price you would pay for HPH stock? Assuming that firm has 60% dividend payout ratio, what portion of the price is attributable to growth opportunities?

19. Solution YearDividends 03.40 1 23.57 33.75 44.31 54.74 1.PV of the dividends from years 1 through 4. PV 0 =$10.81 2. PV of dividends during the perpetual Growth period PV 4 =4.74/(0.14-0.1)=118.50 PV 0 = 118.50/(1+0.14) 4 =$70.16 3. Combining 1 and 2 P 0 =80.97

20. © Dr. C. Bulent Aybar PVGO The firm generates dividend growth because it plows back 40% of its earnings [Plow back ratio =retention ratio=(1-payout ratio) =(1-0.6)=0.4] It is the reinvestment of 40% of earnings that create the growth for the company. If company paid all its earnings as dividends to its shareholders, its earnings and therefore dividends would not have grown. Its annual dividend would stuck at $3.40/0.60=$5.67 perpetually. In this case its value would be: 5.67/0.14=$40.50 This means that the portion of the value attributable to growth is : PVGO= 80.97-40.50=$40.47 The value attributable to growth is referred as Present Value of Growth Options or PVGO. For most high growth companies a major portion of the price is attributable to PVGO.

21. © Dr. C. Bulent Aybar Corporate Free Cash Flow Valuation Method The Corporate free cash flow valuation model takes the PV of all future free cash flows into consideration. Since this PV represents the total value of the firm, the value of debt and preferred stock must be subtracted to get the value of free cash flow attributable to stockholders. Dividing the resulting value by the number of shares outstanding yields the stock price. The free cash flow model differs from the dividend valuation model in two main ways. –The total cash flows of the company are evaluated, not just dividends. –The firm’s weighted average cost of capital is used as the discount rate, not the required return on stock.

22. © Dr. C. Bulent Aybar Example: Kenneth Cole Kenneth Cole (KCP) had sales of $518 million in 2005. Suppose you expect its sales to grow at a 9% rate in 2006, but that this growth rate will slow by 1% per year to a long-run growth rate for the apparel industry of 4% by 2011. Based on KCP's past profitability and investment needs, you expect EBIT to be 9% of sales, increases in net working capital requirements to be 10% of any increase in sales, and net investment (capital expenditures in excess of depreciation) to be 8% of any increase in sales. If KCP has $100 million in cash, $3 million in debt, 21 million shares outstanding, a tax rate of 37%, and a weighted average cost of capital of 11%, what is your estimate of the value of KCP's stock in early 2006?

23. KCP Valuation 2005200620072008200920102011 Sales518.00564.60609.80652.50691.60726.20755.30 Growth9%8%7%6%5%4% EBIT50.8154.8858.7362.2465.3667.98 Taxes18.8020.3121.7323.0324.1825.15 NIFA-3.73-3.62-3.42-3.13-2.77-2.33 NWCI-4.66-4.52-4.27-3.91-3.46-2.91 FCF23.6226.4429.3132.1834.9537.59

24. Enterprise Value and MVE Cash MV of Operating Assets MVD MVE KPS Balance Sheet in Market Values MVE=Market Value of Operating Assets +Cash –Market Value of Debt

25. © Dr. C. Bulent Aybar The Discounted Free Cash Flow Model: Summary Discounted Free Cash Flow Model –Determines the value of the firm to all investors, including both equity and debt holders Enterprise Value Approach –Enterprise Value=Market Value of Equity +Debt-Cash –The enterprise value can be interpreted as the net cost of acquiring firm’s operating assets (acquiring the firm’s equity, taking its cash, paying off all debt, and owning the unlevered business)

26. © Dr. C. Bulent Aybar Growth and Firm Value Consider ABC which is expected to generate $8.33 EPS next year. ABC plows back (retains) 40% of its profits for investment. ABC earns 25% on its equity (ROE=25%). Required return on ABC’s equity by its equity investors is 15%. Based on this data we can tell that ABC’s sustainable growth rate is: g=0.4 x 0.25=0.1 or 10%. Dividend discount model suggest that ABC stock price should be: P= D 1 /(r-g )=(8.33x0.6)/(0.15-0.1)=$99.96 If ABC did not plow any earnings back, its price would be: –P=EPS 1 /r=8.33/0.15=$55.53 This means that value attributable to ABC’s growth options is: –PVGO=99.96-55.53=44.43 or 44% of its value.

27. Putting Growth in Perspective YearNPVEPST=1T=2T=3T=4T=5T=6T=7T=8T=9T=10 12.228.333.330.83 22.449.163.670.92 32.6910.084.031.01 42.9611.094.431.11 53.2512.204.881.22 63.5813.425.371.34 73.9414.765.901.48 84.3316.236.491.62 94.7617.867.141.79 105.2419.647.86 ABC retains 8.33 x 0.4=$3.33 in year 1, and invests this amount. The investment earns 25% return and generates a cash flow of $0.83 in year 2, and all the following years. In other words, $3.33, generates $0.83 perpetually. In the above table I show cash flows until year 10, but they continue perpetually. NPV of this investment is $2.22 as of year 1. In year 2, ABC generates EPS of 9.16, and retains $3.67. This amount is invested in year 2 and generates cash flow $0.92 perpetually starting from year 3. NPV of this investment as of year 2 is $2.44.

28. © Dr. C. Bulent Aybar PVGO The 10% growth generated by 40% plow back ratio and 25% ROE, creates a series of positive NPV investments. This process continues in each of the successive years. Note that NPV1=2.22 created in year 1 grows at a rate of 10% per year, 2.44 in year 2, 2.69 in year 3 and so on. We can calculate the PV of these NPVs by treating them as constant growth annuities. NPV 2.22 grows at a constant rate of 10% perpetually. PV=NPV 1 /(r-g)=2.22/(0.15-0.10)=44.43, which is the same amount we identified earlier. Note that if these reinvestments earned less than 15% return, NPV of these investments would have been negative, and ABCs growth would be destroying value, rather than creating value.

29. © Dr. C. Bulent Aybar When does Growth Create Value? Crane Inc. expects to have EPS of $6 in the coming year. The firm initially planned to pay out all of its earnings as a dividend. With these expectations of no growth and 10% required rate of return on Crane’s equity, current share price is $60. Suppose, Crane decides to cut its dividend payout rate to 75% for the foreseeable future and use retained earnings to open new stores. The return on investment in these stores is expected to be 12%. Assuming equity cost of capital is unchanged, what would be the effect of this new policy on Crane’s stock price? What if the return on investment in new stores is only 8%?

30. © Dr. C. Bulent Aybar Value is destroyed if ROI<Cost of Capital If firm cuts its dividend payout rate to 75% and retain 25% of earnings, it can invest 6 x 0.25=$1.5 per share. If this amount earns a return of 12% as indicated, its earnings and dividends grow g= 0.25 x 0.12=3%. With this growth share price: P(0)=4.5/(0.1-0.03)=$64.28 If the ROI is 8%  g=0.25 x 0.08=2% P(0)=4.5/(0.1-0.02)=$56.25 Note that in the first case ROI>Cost of Equity In the second case ROI<Cost of Equity In order growth to create value ROI should exceed cost of capital!

31. © Dr. C. Bulent Aybar Problem Set #4 Q1: Home Place Hotel Inc. Home Place Hotels, Inc., is entering into a 3-year remodelling and expansion project. The construction will have a limiting effect on earnings during that time, but when it is complete, it should allow the company to enjoy much improved growth in earnings and dividends. Last year, the company paid a dividend of $3.40 per share. It expects zero growth in the next year. In years 2 and 3, 5% growth is expected, and in year 4, 15% growth. In year 5 and thereafter, growth should be a constant 10% per year. What is the maximum price per share that an investor who requires a return of 14% should pay for Home Place Hotels common stock?

32. Home Place Hotel Share Value TDividends 03.40 1 23.57 33.75 44.31 54.74 P 0 =$81.00

33. © Dr. C. Bulent Aybar Problem Set #4 Q2: Nabor Industries Nabor Industries is considering going public but is unsure of a fair offering price for the company. Before hiring an investment banker to assist in making the public offering, managers at Nabor have decided to make their own estimate of the firm's common stock value. The firm's CFO has gathered data for performing the valuation using the free cash flow valuation model. The firm's weighted average cost of capital is 11%, and it has $1,500,000 of debt at market value and $400,000 of preferred stock at its assumed market value. The estimated free cash flows over the next 5 years, 2013 through 2017, are given in the next slide. Beyond 2017 to infinity, the firm expects its free cash flow to grow by 3% annually.

34. Nabor Industries YearEstimated Free Cash Flows 2013200,000 2014250,000 2015300,000 2016310,000 2017350,000 Nabor Industries is considering going public but is unsure of a fair offering price for the company. Before hiring an investment banker to assist in making the public offering, managers at Nabor have decided to make their own estimate of the firm's common stock value. The firm's CFO has gathered data for performing the valuation using the free cash flow valuation model. The firm's weighted average cost of capital is 11%, and it has $1,500,000 of debt at market value and $400,000 of preferred stock at its assumed market value. The estimated free cash flows over the next 5 years, 2013 through 2017, are given above. Beyond 2017 to infinity, the firm expects its free cash flow to grow by 3% annually.

35. Nobor Industries Discounted FCF Valuation Model YearEstimated Free Cash Flows 2013200,000 2014250,000 2015300,000 2016310,000 2017350,000 Value of Operating Assets=Enterprise Value=$3,688,598 Market Value of Equity=EV+Cash-(MVD+MVPS)=3,688,598- (1,500,000+400,000) MVE=1,788,598 Per Share Value =P 0 =1,788,598/200,000=$8.94